Italy’s economy stagnated in the third quarter on the back of the political situation and weak export orders. The outlook remains poor. An euro area exit and an all-out debt crisis are not imminent, but vulnerabilities to shocks are growing.

In the third quarter of 2018, the Eurozone economy grew by 0.2 percent compared to the previous quarter.
October PMI indicators showed a sharper drop than expected, indicating that growth in Q4 will probably remain low.

With a thought experiment we show how Italy could fall out of the Eurozone ‘by accident’. Many wrong policy decisions appear necessary to reach that point. So the risk that it will happen is extremely low.

On 27 September the Italian government presented its budget target for 2019. The worsened outlook has shocked markets and kept them busy since. The government will expectedly temper part of its plans if necessary to calm markets. That said, the risk that it will do too little too late cannot be neglected.

The ECB has little possibilities to stabilize the economy in case of a new recession. Therefore it is important that Eurozone countries have fiscal policy space to fill the gap. Unfortunately the Eurozone countries do not seem to have enough buffers.

Since budget talks took off a few weeks ago, concerns over the sustainability of Italy’s public finances have risen. Italian government bonds yields are up and bank shares are down. Bond yield volatility is here to stay for the rest of the year.

In many Eurozone countries, private sector debt has decreased in recent years and so has the vulnerability of the private sector to higher interest rates. Yet in many countries debt remains high and in several countries vulnerabilities are still present.

Despite deleveraging in recent years, private sector debt remains high in many Eurozone countries. The private sector in Cyprus, Greece, Ireland, Portugal, Spain, Finland and Luxembourg is most vulnerable to higher interest rates.

The short-term economic impact of the current political turmoil is limited. Italy will likely keep the Euro, but a government with Five Star and the League could severely damage debt sustainability and longer term growth prospects.

The Italian elections yielded big wins for populism, but no straightforward workable majority. The economy will manage in the short term, but the potential economic and fiscal fallout in the longer term should not be underestimated.